Financial spread betting has grown to become one of the most commonly used trading derivatives in the UK. The range of markets offered by spread bet firms is comprehensive, covering everything from single stocks and equity indices to commodities, forex, and interest rate products.
Is Spread Betting the Right Choice for You?
Like most other derivatives, financial spread betting has specific quirks and features, and as a trader it’s essential that you make yourself aware of these before you begin to use them. Some of these features may add value, but others can prove costly.
This article discusses the main advantages and disadvantages of spread betting in detail, helping you to make an informed choice about whether this is the right vehicle to help you achieve your trading goals.
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The Advantages of Spread Betting
No Commissions – Spread betting firms make their money through the spread, and don’t charge any fixed commission. This means that all the costs of executing a position are bound up within the P&L of that trade, and there are no further brokerage fees to consider.
Tax Free – This is probably the single most obvious advantage to this form of trading. Unless spread betting is your only source of income, all profits from this activity are currently tax free in the UK.
This can greatly increase the bottom line of your trading business, not least because you’ll have a greater return to compound, but only if it isn’t eroded by the other costs associated with spread betting.
Low Margin Requirements – The margin is the amount a trader needs to have in their account in order to maintain a position. For spread betting, this is often as low as 10%, meaning that with £10 you can, at £1 per point, hold a position in a market that is trading at 100 points. The additional 90% is “borrowed” from the spread bet firm, and as such it gives rise to fees, not all of which are incorporated in the spread.
Many other derivatives can also be traded on margin, though the margin requirements may be higher.
Variable Contract Sizes – Unlike most derivatives, where the value of a contract is fixed, with spread betting the trader determines how much each tick/pip is worth by choosing the exact size of the bet they make. This is normally expressed in ‘pounds per point’.
The position sizing benefits of this and the enhanced ability to compound returns and grow the equity curve exponentially should not be underestimated.
Where a trader of a single futures contract would need to double their account before they began trading two contracts, the spread bet trader could increase their account by, say, just 25%, and be able to increase their position size by 25%, trading in the equivalent of fractions of a contract. This significantly aids the process of compounding, and results in a smoother equity curve.
Note that a similar result can also be achieved, to a lesser extent, using Exchange Traded Funds.
Easy to Short – Shorting individual shares and exchange traded funds can be complicated, as the stock must first be borrowed before it can be sold; with spread betting entering short simply involves a bet that the price is going to fall, and is accomplished at the click of a button in much the same way as for a long position.
Simple to Understand – Compared with many derivatives such as Options, financial spread betting is relatively easy to understand. As such, it can prove an ideal choice for new traders even though they may eventually choose to move on to trade other products.
Understanding the Spread
The spread is the difference between the price at which the spread betting firm will buy from you, and the price at which they will sell to you. Spread betting firms usually quote a relatively wide spread, as this is where the make their profits, and at times of high volatility the spread can fluctuate considerably.
The Disadvantages of Spread Betting
Costly for Illiquid Issues – The spread, which is the main trading cost incurred when spread betting, can be wide for instruments where the underlying market is thinly traded. This is because the spread betting firm will wish to take an equivalent position in the underlying, and the spread will be wide here too. These costs are passed on to you as a trader.
Costly for Daytrading – Even with a good strategy, one of the first challenges for any trader is overcoming costs, especially for daytraders and scalpers whose average profit per trade is lower. Spread betting generally costs more than trading futures contracts, as the spread paid is typically more than the futures spread and commissions combined.
Spread betting is a more viable enterprise for traders who hold positions for several days or more, as the spread costs will have less impact upon trading performance.
No Tax Losses – In much the same way as your spread bet profits are tax free, losses that you incur as a result of financial spread betting cannot be offset against capital gains for purposes of taxation.
Costly for Investing – Spread betting is not really suitable for long term investors because the various costs involved in keeping a spread bet open for an extended period – rollover and maintenance costs – will be prohibitive.
Rollover Costs – Rather like Futures contracts, spread bets have an expiration date, and if you wish to renew your position beyond this date you will typically pay a “rollover” fee.
No Eligibility for Dividends – Because you don’t own the underlying security, you are not eligible to receive dividends or other distributions of profits to shareholders.
Price Quotes – The prices that you see quoted by a spread betting firm are not those of the underlying instrument. The spread betting firm “makes the market” for each price quoted, and so they are at liberty to set that price as they choose, regardless of what may be happening in the underlying market.
Most spread betting firms give descriptive labels such as “Wall Street” to a price quote that roughly tracks the Dow Jones Industrial Average index – though similar, the prices changes will not exactly mirror those of the index, the YM futures contract, or the DIA exchange traded fund, for example.
One of the drawbacks is that this can limit your options for charting to the platform provide by the spread betting company, as these are the only prices that will match those that are actually available to you as a spread bet trader.